[Editor’s note: This is a guest post from Auke Douwe Veenstra, Head of Europe & SA at Cloud Lending Solutions. Cloud Lending Solutions is a Bronze Sponsor at LendIt USA 2016, which will take place on April 11-12, 2016, in San Francisco. In this post he talks about hybrid lending.]
Marketplace lenders are chewing away at two important domains of incumbent banks: lending and investing. These challengers, also called shadow banks, are defined as non-banking institutes who are in the lending business providing similar services to traditional banks. What makes them distinct is that most of them try to stay away from regulators, leverage technology, and have a superior customer experience provided at lower cost. On the other hand, none of these marketplaces have experienced a full credit cycle yet. Should banks be worried? The answer is yes!
Where we are today
Marketplace lending is still relatively small in size, but it’s growing at a fast pace. According to Morgan Stanley Research, the global marketplace could reach $290bn by 2020. Despite all of this, traditional banks don’t show the right sense of urgency at the moment. Where they were once too big to fail, now it seems they’re too slow to move.
Marketplace lending is part of the crowdfunding, or peer-to-peer, market space, but forget the romantic P2P thoughts around this phenomenon. Today, parties such as Citibank, Santander and Goldman Sachs are coming up with their own marketplace lending platforms, or partnering with these new challengers. The main reason why this is so popular is that everybody is looking for yield in the current low-interest environment. Now institutional investors, insurance companies and venture capital are investing heavily in these new platforms in search of better returns for their clients.
What is driving hybrid lending?
What are the main drivers behind this change? As I wrote in my two previous blogs – ‘Lending and the crowdfunding revolution‘ and ‘The rise of hybrid lending‘ – we are witnessing a perfect storm catalyst by the following post-economic crisis factors:
- Regulatory impact. In the aftermath of the crisis, regulations came into effect that have huge impact on the cost of doing business for the banking industry. Compliance-related red tape, combined with stricter capital requirements, are mainly driving this. Moreover, the implementation of Basel 3 & 4 makes a bank think hard where it should place its capital: in a huge corporate loan or in a bunch of small SME-related, labor-intensive and riskier loans. This reality isn’t going to change, so a vacuum is created for this SME segment, where marketplace lenders are jumping in on the cornerstone segment of many national economies.
- Technology. We’re experiencing an exponential growth in technology forcing the current banks to clean up their old systems by replacing them with standard technology at lower cost. Banks are only gradually driving down the cost-income ratios, but they’re still too expensive compared to the new competition. If they don’t embrace standard technology solutions, they will put themselves in serious danger of not surviving. For example, disrupting tech vendors such as US-based Cloud Lending Solutions supplies alternative finance players with online lending platforms, and banks can also benefit from these same platforms, which are operational within 4-6 months at a fraction of the cost.
- Millennials. Over discussed, but for a good reason, millennials are a very important group of change agents. They experience technology as a given and are therefore attached to the convenience factor in their lives. They wonder why they should visit bank branches if banking chores can be done on an iPad. This doesn’t mean they are opposed to branches, but only if it makes sense to use them for complicated matters or financial advice.
What should banks do?
There are basically two ways a bank can respond. They can seek for a partnership with existing marketplace lending (MPL) platforms, which we see happening with ING bank and Kabbage, or Santander in the UK with Funding Circle. Fintech platforms find this interesting because they see this type of hybrid lending will become the new normal. Moreover, they can tap into the experience of banks running full credit cycles. Banks, at the end of the day, still like to continue servicing important segments such as SME business, and via partnering with external marketplace players, this seems to be a viable option. But, banks lose the borrower and investor relationship with this path. These relationships are the strongest asset banks have today to remain viable.
The second option banks have is to start their own marketplace lending platform and combine this with regular forms of lending to create a hybrid lending platform. I see the first banks who are making moves into this direction, which I think is visionary.
Hybrid lending is where banks, driven by Basel 3 & 4 solvency requirements, optimize their balance sheets by combining regular balance sheet lending with off-balance sheet via their own marketplace lending. This seems to be the recipe for success for those sectors that appeared less attractive due to the capital withholdings, such as SME lending and real estate.
With hybrid lending, a bank can extend more loans into the less attractive sectors, rather than turning down the entire loan. For example, an SME comes to the bank for a $1 million loan. With the new Basel 3 & 4 requirements, the bank may find that loan too risky to make. With their own hybrid lending marketplace, the bank could take a portion of that loan as part of their standard balance sheet lending (the amount that fits their balance sheet risk model), and put the remainder into their marketplace for investors to fund. This solves both borrower and investor relationship issues as well. Banks can retain their valuable borrower customers that they had to turn down before, at the same time they retain their valuable investors that are looking for higher returns in third party marketplaces. Now, these investors have the ability to continue to work with their bank, and receive higher returns.
Hybrid lending, as the new normal, will become the answer to optimize a bank’s balance sheet, while allowing them to keep their entire loan portfolio. Right now, banks have two choices to comply with Basel 3 &4: Reduce their portfolio by selling off assets to comply, or restrict making new loans to the least risky market segments. Neither option is attractive compared to the new hybrid lending these innovative banks are moving toward. If you are interested in hearing more about this solution, please come see us at the upcoming LendIt in San Francisco.
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